Creating the Most Growth: Picking the Right Tax Cuts

About the Author

As the tax package
becomes smaller, it is imperative that Congress focuses on those
provisions that cause the most economic growth. While a tax bill at
only $350 billion greatly reduces the potential for economic growth
under the President's original plan, higher levels of economic
growth can still be achieved if Congress enacts the best provisions
of the President's plan.

Tax measures,
which increase people's incentive to work, invest and save,
contribute the most to economic growth[2]. Hence, certain types
of tax measures, no matter the size, could generate much more
growth than larger provisions, which fail to encourage investment
or work.

The best tax cut
for the money, listed in order of creating the most growth:

In January,
President Bush asked Congress to pass a tax cut over the next ten
years worth $726 billion.[1]
Congress responded by passing a budget resolution calling for $550
billion in tax relief. While Congress's response fails to address
the heavy burden of taxation borne by taxpayers as aggressively as
the President's plan, the passage of $550 billion in tax cuts would
still constitute one of the largest tax relief packages in recent
history. However, the chairman of the Senate Finance Committee,
Senator Chuck Grassley (R-IA), vowed that the Senate would pass
only $350 billion in tax relief unless reductions in spending were
made to pay for more tax relief.

Action

In this report, we
model the President's tax provisions and some other tax proposals
to show their separate effects on the economy. The tax provisions
we analyze differ based on their total savings to taxpayers and how
they change incentives to work, invest and save. The report focuses
on these specific components' effects on GDP growth, job growth,
budget cost, and their impact on American families.

Complete
Elimination of the Individual Tax on DividendsThis provision will cause the most growth.

President Bush
took another bold step towards fundamental tax reform by proposing
the end to the double taxation of dividends. Currently, dividends
are taxed once at the corporate level and again at the individual
level when dividends are paid to investors. The President's plan
would end the taxation at the individual level. This tax relief
lowers the cost of capital on businesses, which makes it easier for
businesses to expand their operations and for entrepreneurs to open
new businesses.[3]

The CDA estimates
that on average from 2004-2008 eliminating the double taxation of
dividends would create 498,000 new jobs, $44.6 billion in real GDP
and increase disposable income by $72 billion. For every dollar of
additional debt, this tax reform produces $5.84 in additional
income.

Setting
the Dividend and Capital Gains Tax rate at 5/15
Percent

This provision
will encourage growth for many of the same reasons of complete
repeal: the tax rate on capital investment declines spurring new
business investment. However it will not generate as much economic
growth as the President's plan because it does not eliminate the
double tax on dividends.

Because of budget constraints, other options have been
proposed to reduce the taxation of dividends. One of the ideas,
promoted by House Ways and Means Chairman Bill Thomas (R-CA), is to
tax dividends and capital gains at the same rate; 5 percent for
those who pay individual income taxes at the 10 or 15 percent
bracket and 15 percent for those in all other brackets. While this
does not end the double taxation of dividends, it does reduce the
top tax rate on capital gains by twenty-five percent and
substantially reduce the taxes that investors must pay on
dividends.

The CDA estimates
that on average from 2004-2008 eliminating the double taxation of
dividends would create 367,600 new jobs, $30.9 billion in real GDP
and increase disposable income by $38.7 billion. . The total
savings for this proposal are estimated at $277billion from 2003 to
2013.

Increase
Bonus Depreciation to 50 Percent and Extend Through 2005This provision expands the depreciation deduction enacted
in 2002 that allowed businesses to deduct up to 30 percent of the
cost of qualified property[4]
used for business purposes. Economists estimate that this could
reduce the cost of capital by four percent a year for businesses[5]. In turn, this
reduction would cause businesses to invest more, thus growing the
economy.

The increase and
extension in the House bill would increase the deduction to 50
percent of the cost of qualified property and extend the provision
by one year (to 2005). The Joint Tax Committee estimates that the
static cost of this provision is $21 billion over ten years and $78
billion from 2004 to 2008. CDA economists estimate that on average,
from 2004 to 2008, the bonus depreciation would create 93,400 new
jobs, $8.6 Billion in real GDP and boost disposable personal income
by $14.5 Billion.

Accelerate the Marginal Rate
Reductions and Expand the 10% bracket

This provision
would reduce the income tax for millions of tax filers. It provides
strong economic growth because working Americans get to keep more
of what they earn.

Marginal rate
reductions, originally scheduled for 2004 and 2006, would be fully
implemented in 2003 under the President's budget. The 38.6 percent
rate drops to 35 percent, the 35 percent rate drops to 33 percent,
the 30 percent rate drops to 28 percent and the 27 percent drops to
25 percent. The tax bill also helps those in lower income
groups by expanding the 10 percent bracket. More of these
taxpayers' income will be taxed at 10 percent instead of 15
percent, thus they would keep more of what they earn.

The CDA estimates
that on average from 2004 to 2008 accelerating the rate reductions
and bracket expansion would create 130,000 new jobs, $12.6 billion
in real GDP and increase disposable income by $31.6 billion. For
every dollar of additional debt, this tax reform produces $2.14 in
additional income.

Marriage
Penalty Reform

This provision
would provide some economic growth.

The President's
budget would enact the marriage penalty reform immediately in 2003
rather than wait for phasing in tax relief between 2005 and 2010.
The standard deduction for joint filers would be increased to
twice that of single filers and the starting point of the 28
percent bracket would be set at twice that of the single bracket.
This would end two of the different penalties that hurt joint
filers.

This provision
will provide some economic growth because a number of duel-earner
families would not pay as much in taxes simply because they are
married. Therefore, this provision would raise the incentives of a
family's secondary earner to work and earn more. Other families
will receive a marriage bonus if they have only a
single-earner.

CDA economists
estimate that on average from 2004 to 2008 marriage penalty reform
will create 42,000 new jobs, $4.4 billion in real GDP and increase
disposable income by $13.7 billion. For every dollar of additional
debt, this tax reform produces $1.66 in additional income.

The Child Tax Credit

This provision
does not create much economic growth.

The President's
budget proposed to speed up the increase of the child tax credit
from $600 to $1000 per eligible child. Originally, this increase
would be gradual and phased-in from 2005-2010. The new proposal,
which results in tax savings of $90 billion in the next ten years,
immediately increases the credit by $400 per eligible child. While
this increase helps families, it does create much economic growth.
Families have no incentive to invest more and the income phase-out
of the child tax credit actually creates a disincentive to earn
more. Furthermore, this is only speeding up a tax break that is
scheduled to happen anyway.

CDA economists
estimate that from 2004 to 2008 the child tax credit will create
44,000 new jobs, $5.3 billion in real GDP, and increase disposable
income by $16.5 billion. For every dollar of additional debt, this
tax reform produces $1.62 in additional income.

The Final Tax Cut
Package Should Include the Most Pro Growth Provisions

Tax policy changes
can enhance the rate of economic growth when they improve the
incentives for work, saving, and investing. Businesses grow when
they have lower costs allowing projects to become profitable that
otherwise would not be undertaken. With the amount for tax relief
already set by the budget agreement, Congress should focus on tax
proposals that create the most economic growth for the smallest
static price and accept a tax cut that fulfills the budget
agreement of $550 billion.

Reducing the tax on dividends and accelerating
the marginal rate provisions of 2001 are the two best elements of
the tax cut. They cause the most job growth and return the best
value for their cost. Congress should also expand the depreciation
bonus and expensing for business. The provisions cause strong
growth in the early years by reducing business costs. Marriage
penalty reform and the child tax credit do not cause enough
economic growth to be included in a package that can only be a
maximum of $550 billion.

Rea S. Hederman,
Jr. is Senior Policy Analyst in the Center for
Data Analysis at The Heritage Foundation.

[1] As scored by the Joint
Tax Committee in "Estimated Budget Effects of the Revenue
Provisions Contained in the President's Fiscal Year 2004 Budget
Proposal," JCX-15-03, March 4, 2003.[2] For further
information, read Dan Mitchell's Webmemo #263 "Understanding
Pro-Growth Tax Policy" April 18, 2003. http://www.heritage.org/research/taxes/wm263.cfm.[3] See Norbert J. Michel,
"Everyone Profits From Hurdling Dividends," WebMemo #248, April 3,
2003, at http://www.heritage.org/Research/Taxes/wm248.cfm.[4] The Job Creation and
Worker Assistance Act of 2002 created this business depreciation
originally scheduled for only three years, expiring at the end of
2004. Qualified property covers many capital expenses a business
would purchase from computer software to physical property.[5] Cohen, Darryl, Hassett,
Kevin and Hansen, Dorthe-Pernille, "The Effects of Temporary
Partial Expensing on Investment Incentives in the United
States", National Tax Journal, Vol. LV, No. 3, September
2002